Banks would rather lend to govt than give you cheaper loan

The State Bank of India (SBI) cut its base rate by 5 basis points (i.e. 0.05 percent, one basis point is one hundredth of a percentage) to 9.7 percent in response to the Reserve Bank of India (RBI) cutting repo rate by 25 basis points (i.e. 0.25 percent). Guess it was their idea of a 'bad' joke. Repo rate is the interest rate at which the RBI lends to banks.

While newspapers have gone to town trying to tell you and me that interest rates are falling, nothing like that has happened. A few banks have cut their auto loan rates but no major bank (other than SBI) has cut its base rate. Base rate is the lowest rate of interest at which a bank can lend.

Why has that been the case? Numbers tell a really interesting story. Reuters

Why has that been the case? Numbers tell a really interesting story.

As on 30 March 2012, banks had invested 28.55 percent of their deposits in government bonds. This number has since gone up and as on 11 January 2013, banks had invested 30.23 percent of their deposits in government bonds.

This means that during the course of this financial year (i.e. the period between 1 April 2012 and 31 March 2013) the banks have invested in government bonds a greater proportion of the deposits they managed to raise.

The government issues bonds to finance its fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends.

What is interesting is that banks have to maintain a statutory liquidity ratio of 23 percent, i.e. invest Rs 23 of every Rs 100 raised as demand and time deposits compulsorily into government bonds. But as of 11 January 2013, for every Rs 100 collected as deposits, banks had Rs 30.23 invested in government securities. And this has gone up from Rs 28.55 as on 30 March 2012. This in a scenario where banks need to invest only Rs 23 out of every Rs 100 raised as deposits in government bonds.

This tells us that banks would rather lend more to the government than you and me. This excess money chasing government bonds has led to a situation where the return on government bonds has fallen. The return on a 10 year government bond as on 30 March 2012, stood at 8.54 percent. On 11 January 2013, it was at 7.87 percent.

This excess lending and lower returns on the government portfolio have meant that banks need to continue charging high interest rates on the loans they make to consumers, in order to continue maintaining their profit levels. And that explains to a large extent why they haven't cut interest rates despite the Reserve Bank cutting the repo rate by 0.25 percent.

The question to ask here is why are banks happy lending to the government rather than you and me? Is it lazy banking? Why bother lending to individual consumers when you can lend in bulk to the government? Or are banks facing more losses on their lending and hence are sticking to lending to the government? Lending to the government is deemed to be safe given that even in the worst possible scenario the government can always print and repay money.

Or is it a case of the government forcing public sector banks to invest a greater amount of their deposits than is required as per the law of the land, in government bonds?

Whatever be the case, this excess lending to the government has led to a situation where banks are unable to cut interest rates.

It has also helped the government, allowing it to easily raise money from banks to finance its massive fiscal deficit at lower rates of interest. The fiscal deficit targeted for this financial year (i.e. the period between April 1, 2012 and March 31, 2013) was Rs 5,13,590 crore. For the period April to November the fiscal deficit stood at around Rs 4,13,000 crore. This means that during the first eight months of the year, the fiscal deficit crossed 80 percent of the budgeted estimate.

If we project the fiscal deficit number for the first eight months for the entire financial year it is likely to come to Rs 6,16,000 crore, which is Rs 1,00,000 crore more than the budgeted fiscal deficit. And if the banks continue to help the government as they have in this financial year, the government can keep running its huge fiscal deficit rather easily.

There had been great pressure on the RBI governor D Subbarao to cut the repo rate. He had resisted the idea for a while now despite repeated hints given by the government in general and the finance minister P Chidambaram in particular. Now that he has gone ahead and cut the repo rate, it is not translating into subsequent cut in interest rates by banks.

In an interview to The Economic Times former RBI governor YV Reddy explained the friction between a central bank and the government by saying "A central bank that is always in agreement with the government is superfluous, just as a central bank that is always in disagreement is obnoxious. The solution really is to have messy coordination."

To conclude, there is not much that the RBI can do to bring down interest rates. That will only happen once the government is able to control its fiscal deficit. And that is not happening any time soon. So higher EMIs and interest rates are here to stay.